He is at it again! Last week Mario Draghi confirmed that the ECB’s Governing Council was “unanimous in its commitment to using unconventional instruments within its mandate to cope effectively with risks of a too prolonged period of low inflation”. Effectively he has said that the ECB will take the necessary action to help steer economies to its targeted inflation rate of two per cent. This time however, his Italian charm is unlikely to coax markets into accepting his rhetoric without following up with real action.

The ECB has been shown to consistently underestimate the degree to which inflation is falling within Europe. And with the euro remaining stubbornly high, the problem of deflation is potentially exacerbated. As European governments remain bursting to the seams with debt (debt to GDP in excess of 100 per cent), prolonged low inflation or even worse – deflation – could lead countries, such as Italy, into default as the servicing cost of their debt becomes unsustainable in the absence of a fast growing economy.

The statement made following last week’s ECB meeting is therefore important because for the first time it shows that the ECB including Draghi’s German colleagues now appear open to using “unconventional” means to help push economies forward and stave off deflation.

What does this mean in practice? This is more difficult to tell.

As good as he is, Draghi is no Merlin. He cannot singlehandedly pull European economies out of their current predicament. Individual governments need to do their bit to restructure their economies. Not surprisingly the French and Italians have failed to take the bull by its horns and push through sufficient reforms. Instead they keep procrastinating in the hope of placating their voters. The danger here is that the EU, driven by the likes of Germany and Finland, takes a tougher line, forcing these governments into action and thus feeding the growing right-wing support that has mushroomed.

Unlike the Fed and the Bank of England, the ECB has, as yet, not embarked on a policy of Quantitative Easing (QE) or printing money. According to the EU Treaty, the ECB is not permitted to assist in financing governments. Even buying government bonds from the secondary markets requires some loose interpretation of the treaty, though recent statements from Bundesbank officials, however, point to some relaxation of their hardline approach in this context.

If the coast is clear to undertake QE then what is the form that this will take? As Draghi pointed out, European economies are structured differently to the US and UK. Capital markets have less of an influence on overall credit in Europe than in the US and the UK. Hence the linkage between the sort of QE we are now used to and the economy in the wider context is less certain in a European context. The ECB therefore needs to think outside the box on what its objectives are and how to achieve them. Additionally the fact that the EU is made up of 28 different member states (18 in the eurozone) creates difficulties of allocation. Is the ECB going to favour buying assets of one state versus that of another? Ultimately the ECB wants to stimulate growth in credit. This can be done by reducing the cost of credit and making cash available to lend.

In Europe credit lending happens predominantly within the banking sector, hence any programme that is devised needs to focus on stimulating banks to lend more. You cannot push a piece of string though! Banks need to continue rebuilding and strengthening themselves, and learn how to live in the new world of banking regulation before making credit easier. This will take time. In the meantime the ECB is looking at ways to buy loans, in the form of asset backed securities from banks. This may take even longer!

In the meantime the market has continued to push yields on European periphery bonds to the lowest since the financial crisis. Given the risks of low inflation, low yields on bonds are here to stay for a significant period of time. While low real yields are not good news for savers, it explains why there was such heavy demand for the Maltese government’s latest auction of 4.45 per cent 2032 paper last Friday. Just four weeks ago institutions bid for €15.3m of paper. Last week they bid for almost €70m.

This is also good news for potential domestic bond issuers. Although the year has started slowly, momentum in the new issue market is set to gather pace with three issues due to hit the market in the coming weeks.

Thereafter a number of other issuers will also try their hand at selling bonds to the public.

Given the outlook savers may do well to selectively use these opportunities to supplement their income levels by buying into some of these bonds. In the meantime we hope that Draghi realises that actions speak louder than words.

info@curmiandpartners.com

This article is the objective and independent opinion of the author. The information contained in the article is based on public information.

Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

David Curmi is managing director at Curmi and Partners Ltd.

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